Hedge Funds, Private Equity Brace for Tax Hike

Private equity, real estate and hedge fund managers are increasingly resigned to a tax increase on their profits as U.S. lawmakers get set to vote on a long-delayed measure.

At issue is a change in the tax treatment of profits earned by partnership fund managers, known as "carried interest." The measure would treat the profits as ordinary income subject to a 35 percent rate, more the double the 15 percent rate they are currently taxed at as capital gains.

The tax change, which lobbyists have managed to beat back for three years, has gained steam as lawmakers hunt for revenue to fund other popular tax breaks for business that have expired. Many lobbyists and former opponents now see passage of an increase as inevitable.

"Many people are resigned because it is round four," said Francois Hechinger, a partner at BDO Seidman advising private equity and venture capital clients..

He added that they are still putting up a fight to try to soften the impact.
"If it was really their choice they wouldn't give up on it at all."

The $20 billion or so of revenue that the tax change could raise over a decade would help pay for a politically popular group of tax breaks for individuals and business, including a corporate research and development tax credit.

Lawmakers have run out of revenue raisers as the year has progressed, partly because the easier raisers were lost to pay for the long-fought healthcare overhaul.

Wall Street money makers are also a good political target in the aftermath of the financial collapse in 2008 and the stalled recovery.

"Democrats obviously need the money. They are going into an election where they are a lot less confident," said Roger Lorence, a lawyer for hedge funds and private equity.

Lorence contends the measure to increase taxes, likely to soon reach the floor of the U.S. House of Representatives, is shortsighted because it doesn't take into account people who took risk and got completely wiped out during the recent downturn.

In the most likely scenario, the tax change would be attached to a must-pass unemployment insurance bill with a deadline of the end of May. Various compromises, including a phased-in implementation and adoption of a rate between the 15 percent capital gains and 35 percent ordinary income rate, are being considered to soften the impact.

President Barack Obama backs the change and his budget chief, Peter Orszag, told Reuters this week he predicts it will pass this year.

To be sure, the provision could stall again in the Senate, where it has less support and where other priorities compete for time on the Senate floor.

In a potential complication that came to light on Thursday, five Democrats wrote leaders of the Senate's tax-writing Finance Committee seeking an exemption for venture capital.

"Removing the capital gains tax status for the carried interest earned by these venture capitalists when companies are successful will be a harmful disincentive," they wrote in a letter dated May 11.

Still, the odds are better than in any of the past three years.

The real estate industry, which has helped successfully stave off the tax increase for several years, has indicated it could live with a compromise in which investors holding assets for three or five years could keep capital gains treatment, according to a lobbyist at the trade group Real Estate Roundtable.

"I think the real estate industry would be amenable to that," the lobbyist said.

The carried interest law, which began decades ago, applied to the oil and gas industry, according to lawyers.

It lives today through master limited partnerships, or MLPs, a structure in which the partnership pays no corporate taxes and distributes all its profits to "unit holders" rather than shareholders.

The various industries affected — real estate, venture capital, private equity and hedge funds — are trying to make deals to lessen the impact of the tax on them.

But Sander Levin, the top Democrat on the tax-writing Ways and Means Committee in the House of Representatives, has taken a tough "no carve-outs" line.

"I have no idea whether the industry is resigned or not, but kicking or smiling, I think they are about to be hanged," said one industry lobbyist, who could not be quoted for attribution.

If it passes, tax lawyers will start planning ways to get around the new tax, said Steven Kaplan, a finance professor at the University of Chicago.

"You'll very quickly get lawyers structuring around it, and it will create work for lawyers," Kaplan said.

He said it could create tension between limited partners — the pension and endowment fund investors that put money in private equity funds, and general partners, the private equity executives running the funds — because there will be ways to get around it.

Private equity, real estate and hedge fund managers are increasingly resigned to a tax increase on their profits as U.S. lawmakers get set to vote on a long-delayed measure.
At issue is a change in the tax treatment of profits earned by partnership fund managers, known as ...